Facing the Markets: Moats and Money

Facing the Markets: Moats and Money

A Wide and Deep Moat Can Mean Greater Safety

In the olden days, a moat meant a protective trench, preferably wide and deep, around a structure such as a castle. A well-constructed moat protected those inside, gave them a feeling of at least some security and –in effect — provided a visual reminder of their safety.

It often dissuaded opposing forces who sought to invade the castle and the wider and deeper the moat, the stronger the reassurance and defense.

The moat principle can be applied to stock selection and in some cases, it will provide a feeling of security. A company with a wide and deep economic moat has strong advantages over competitors and would-be competitors. Those advantages protect its market share and by extension the share price. Among those advantages, size, scale, strong branding and cost of entry into the market top the list. Even intensely loyal customers can be part of the moat.

Credit card companies (more accurately called payment networks) have all of these advantages and taken together they provide major barriers to entry from would-be competitors. The cost of setting up the kind of networks owned by MasterCard would be enormous and the chances of winning over sufficient customers and revenues to make a start-up network profitable would be exceptionally slim. By comparison, auto manufacturing behemoths such as Ford and General Motors cannot claim to have moats, given the intense competition between domestic auto manufacturers and the aggressiveness of foreign car manufacturers.

The presence of an economic moat does not automatically make a stock appropriate for your portfolio. The absence of a moat does not definitively preclude a stock as an investment but does mean looking for other strengths in the company’s performance or assets. Discuss this with your financial advisor. A stock may very well have other characteristics that make it suitable.

Moreover, the presence or absence of a moat does not automatically mean that a stock will be more or less volatile. That is especially important this year as we have seen a return to volatility in the stock markets after the relatively low volatility of 2017.

Among Canadian stocks, CP Rail has a wide moat. Morningstar Inc., a leading investment management company, cites a list of attributes including its cost advantages, scale and fuel efficiency over other freight shipping modes such as trucking. Perhaps most important, CP’s track network which spans Canada and parts of the United States would be impossible to replicate.

Among American stocks, the Bank of New York Mellon has a wide moat due to its cost advantages, economies of scale, the size of its global custody business, the near-zero added cost of offering new services and the potentially profitable fallout from increasing regulation. Union Pacific Corp., an American railway, gets a wide moat rating for reasons similar to Canada’s CP Rail.

Canadian stocks with a narrow moat include Lululemon Athletica Inc. Morningstar had previously refrained from assigning a moat rating due to questions about the sustainability of the company’s returns. It now assigns the narrow moat rating due to intangible assets such as brand identification and ability to withstand competition.

American stocks with a narrow moat include Huntington Bancshares, due to its auto-financing business, cost efficiencies and greater economies of scale following its successful integration of FirstMerit Corp.

Applying the moat concept can lead to some surprises. Canada’s SNC-Lavalin has many strengths but lacks an economic moat, according to Morningstar. SNC-Lavalin is reshaping itself with a critical mass of intangible assets, the agency explains, adding that competition for engineering and construction projects has intensified, especially for smaller scale projects. Blackberry also ranks as a no-moat company in the absence of any factors giving it a strong competitive advantage.

Among American stocks, the much beaten-down GE has a wide moat, according to Morningstar, a judgement it bases on GE’s. long-term customer relationships, patents, strong brand, installed base of industrial equipment and its tangible and intangible assets. That equation may provide some very long-term comfort for those who hold the stock and have not sold it off, though it will take some years to prove the point. Equally surprising, scandal-ridden Wells Fargo Financial & Co. has a wide moat, as a result of factors such as its success in deposit-gathering, risk management, and operational efficiencies, Moreover, the fact that account closures — amazingly — did not spike as dramatically as expected during the revelations of its sales practices suggests a high degree of customer loyalty.

(Disclosure: I do not own shares in any companies mentioned in this article and have no plans to acquire any of them.)